QUESTIONS:
1). Discuss the four possible capacity levels a firm must evaluate when deciding how to set budgeted fixed manufacturing cost rates, including the pros and cons of selecting each capacity level. Explain the potential impact this decision would have on firm profitability.
2).Using this week's lecture, discuss the concept of relevant cost for decision making, incorporating both quantitative and qualitative data concepts into the relevancy discussion. Indicate if and how opportunity costs should be considered in this decision-making process.
WEEK'S LECTURE
When a manager needs to make a decision about something, anything really, the manager is primarily interested in the information that will change among the various alternatives. If the data does not change, then it is not relevant to the particular decision at hand. This is called differential analysis. As such, only information that actually may help change our decision is relevant information. For example, If we paid $800,000 for some equipment one year ago, and some new equipment comes out that will run twice as fast with half the labor requirement, then the cost of the old equipment ($800,000 in this example) becomes irrelevant (because it is a sunk cost) to the decision of whether we should upgrade to the new equipment or not. The factors that are relevant are the cost of the new machine, the number of pieces of product the new machine will produce compared to the old machine (difference), the difference in labor cost between running the old machine and the new machine on a per unit basis, and any utility savings that may incur. We would also consider any tax implications we may encounter and any disposal value related to the old machine.
Watch the following video: Part 1 - Relevant Costs for Decision Making: Sunk and Differential Costs
So where can we use this logic we are covering? Well, full cost and special order pricing come to mind. Under full cost pricing of a product we calculate the variable and fixed cost on a per unit basis and then apply this to the new product. This sounds reasonable, right? We do have to cover all costs in order to make a profit. However, if the fixed costs are present whether or not we produce and sell this product, then the fixed costs become irrelevant to our decision. Why? Because, if we do not produce this product, then those fixed costs will be reallocated among the remaining products. So, how is this useful to us? Well, when a customer approaches us about a special price for a bulk order of our product this information will come in handy. In theory, any price for our product that is over and above the product per unit variable cost should be considered assuming excess production capacity exists and the special pricing will not be known or utilized in markets in which we already have customers.
Here is a short video that demonstrates this concept: Part 5 - Relevant Costs for Decision Making: Special Order
Another offshoot of this discussion would be a make or buy decision. This type of decision also uses differential costs to determine if a product should be made internally or purchased from a supplier. While the cost analysis is relatively straight forward, the item most frequently ignored in this type of analysis relates to qualitative rather than quantitative factors. Qualitative concerns would be things like the firm's ability to ensure a steady product supply and the quality of the product or part being purchased, among other things.
Take a look at this short video relating to make or buy decisions, keeping in mind that there are some things you cannot put a dollar figure to (like piece of mind when you control your own destiny, for example): Decision Making & Relevant Information: Make-or-Buy, Part 1 - Accounting Video.
This same sort of analysis also applies to a decision to keep a product line or drop it: Part 3 - Relevant Costs for Decision Making: Drop or Retain
Now that we have relevant costs firmly fixed in our mind, we take up the topic of cost estimation. Why use an estimate, you say? Well, for one, we may not know exactly which component we will ultimately use in a product if research is still being conducted, but we still may need a rough cost figure to work with to determine if the end cost of a potential product is anywhere in the ballpark with the market pricing of this product. Cost accountants and other managers conduct all sorts of "what if" type analysis when looking to the future, and there are usually unknowns that need some assumptions to be made to create an estimate to be used for the analysis.
Certainly it is necessary to know how a cost behaves when conducting any sort of analysis. Categorizing costs as fixed or variable is usually necessary. Then a determination about what sort of estimate to use is required. Estimates could be an engineering estimate, where time and motion studies are conducted, and a detailed analysis and consideration of components and their cost drivers.
Another estimate that is sometimes used is the account analysis. With this approach, the accountant analyzes each account utilized in an existing activity and compares the type of costs (fixed or variable) and the impact each cost has on the overall cost of producing a fixed number of items. The resulting cost formula is: TC=FC + VX where TC is Total Cost, FC is Fixed Cost, V is variable cost and X is volume.
While engineering estimates and account analysis have their place, each has some limitations that can require some additional work to validate the results. A third method that overcomes many of the limitations of the other methods is Statistical Cost Estimation. Within some defined relevant range of activity this method, though based on historical information, can create a very practical way to estimate future costs. To make this comparison more representative, variables can be adjusted for known changes, like an expected inflationary increase percentage for purchase price of materials, for example.
One statistical method often used is called the High/Low cost estimation. Under this approach the variable cost per unit is derived utilizing the formula: (Cost at highest activity level - Cost at lowest activity level)/(Highest activity level - Lowest activity level). Then we take the total cost at either activity level and subtract the variable cost to get the fixed cost. Finally, we apply the figures to our cost formula previously postulated where TC=FC + VC.
Here is a short video with an example: Cost Analysis Part 2 - The High Low Method: Management Accounting
Another statistical method used is called regression analysis. With spreadsheets and statistical calculators today, this method becomes much less tedious than in periods past. This is a short video you might find useful for a better understanding of this concept: Cost Analysis Part 4 - Least Squares Regression Method in Excel: Management Accounting.
3). Explain the value of a customer-profitability analysis in making management decisions about future operations. Are there times when a company would be better off without a particular customer? If so, explain the scenario and indicate how you might approach a customer that fits that category to address the issue.
4). Referencing this week's lecture, explain in your own words and give a numerical example of the allocation of multiple support departments to a production department utilizing the direct, step down, and reciprocal methods. In addition, explain what impact the allocation method might have on management decision making.
WEEK'S LECTURE:
We have seen how various costing issues are handled in our previous work. Now it is time to see how the results are applied and used by management to make decisions about running the business. Previously we studied activity based costing. Now we take that information and apply it to what we call activity based management.
Now that we have identified the costs and what drives them, we can take that information and use it to try and reduce costs to improve the firm's profitability. This requires changing activities, since that is what drives costs. So the focus has shifted from studying the costs themselves to studying the activities that drive the costs, which intuitively makes a lot of sense, don't you think? If a firm has extra steps involved in the manufacturing process, or in the design process of a product, that costs money. If we eliminate those extra steps, the costs are also typically eliminated. We call this eliminating non-value added costs. Examples of non-value added processes, in general terms, are those that involve storing, moving, waiting, or other such activities in the production process. In a retail environment, it would be cheaper for a bank if customers did their banking online or via a cash machine, right? That would eliminate unnecessary labor. See where we are going with this? Take a few minutes and check out this video that deals with activity based management to get a better handle on what we are talking about.
Capacity is a separate issue, but related to activity based management because capacity is activity (volume) based. Does excess capacity have a cost? Sure it does...lost revenue is an opportunity cost, right? So a manager who is faced with excess capacity needs to find a way to utilize this capacity productively to generate a return on the investment. It seems to make sense when we look at lost revenue. In addition, quality has a cost component as well, so the cost of quality is directly related to the activity put into insuring a quality product is being produced.
Take a look at this 2 minute summary: Quality Cost
So, now that we are in the cost mode, let's look at service department cost allocations. What are service departments? Well, they are departments that serve others, like accounting, human resource, data processing, or maintenance, for example. Why must we allocate them? Because they would not exist unless others need their services. No company can function long without some HR individuals, right (could be internal or could be outsourced, but there is cost either way)? User departments would be a department like a production department, or, in many cases, another service department (the accounting department also uses HR services). There are multiple methods used for this allocation, but the primary ones are the direct method, the step method, and the reciprocal method. While each works a little differently, the basic concepts are similar.
MY BOOK THAT I AM USING IS: Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A managerial emphasis (15th ed.). Boston: Pearson